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What is operating leverage in special financing?
Operating leverage is ratio between company’s fixed costs to its variable cost. It tells about how company is using its fixed cost to regenerates its revenue. If the fixed costs are high, company generates high leverage ratio which leads to high profits.
If the fixed costs are low, company will generate low leverage ratio and leads to low profits. Operating leverage calculates company’s breakeven point and tells about the effectiveness of pricing structure.
Scenarios of leverage ratio are as follows −
- High operating cost − Company will earn larger profit, when it attains sufficient sale volume to cover its fixed cost.
- Low operating cost − Company will earn smaller profits, when it doesn’t generate sale volume to cover its fixed cost.
Degree of operating leverage
Degree of operating leverage quantifies risk arises due to structure of fixed and variable costs. A low DOL tells company have more variable cost than its fixed cost, means increase in company sales but is not operating income. Similarly, a high DOL means fixed cost exceeds its variable costs means, company increases it operating income by increase in its sales.
Degree of operating leverage = change in percentage in operating income/change in percentage of sales
Or
Degree of operating leverage = contribution margin/operating income
$$=\frac{number\:of\:units\:(price\:per\:unit-variable\:cost\:per\:unit)}{number\:of\:units\:(price\:per\:unit-variable\:cost\:per\:unit)-fixed\:costs}$$
Example
A company sells 15,000 products units at an average of $45. The variable cost per unit is $9, while fixed costs are $125000. Determine company’s degree of operating leverage.
Solution
The solution is given below −
Number of units = 15000
Price per unit = $45
Cost per unit = $9
Fixed cost = $ 125000
Degree of operating leverage = contribution margin/operating income
$$=\frac{number\:of\:units\:(price\:per\:unit-variable\:cost\:per\:unit)}{number\:of\:units\:(price\:per\:unit-variable\:cost\:per\:unit)-fixed\:costs}$$
$$=\frac{15000(45-9)}{(15000(45-9)-125000)}$$
$$= 1.30$$
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